Civil Engineering Reference
In-Depth Information
Figure 14.3
The money market
£'s
Customers
Finance
Houses
&
Merc
h
ant
Banks
Bank
of
England
High Street
(commercial)
ba
n
ks
Customers
assets
Customers
Repo rate
LIBOR
Saving and borrowing rates
Part of the problem was the fact that central banks kept their rates close to
zero for a significant period: a base rate of 0.5 per cent led the interbank market
for more than three years from March 2009 onwards. However, a low base rate
no longer provided a guarantee that other rates would stay low or that funds
would actually be lent. The credit crunch had led to an abrupt change, financial
stability was replaced by instability and markets went into 'crisis' mode. There was
a distinct loss of trust between banks, and lending between banks dried up. They
also became reluctant to lend to borrowers. This had severe consequences for the
wider economy. Parkinson et al. (2009: 4) noted the downward cycle in the property
and construction sector, where it quickly became evident that the financial turmoil
meant that lenders would no longer lend, borrowers could not borrow, builders
could not build and buyers could not buy. In the simplest of terms, the credit crunch
had starved the economy of its productive capacity.
This raises a significant policy challenge, particularly if monetary policy focuses
too much on inflation and not enough on financial stability. When official interest
rates get close to zero the effect they have on regulating the economy becomes
muted. Consequently, governments seek another way of affecting the price of
money. One approach is to increase the supply of money circulating the economy.
This is done through a process known as
quantitative easing
, and it has only been
tried in Japan, the United States and the UK. Between March 2009 and July 2012,
the Bank of England pumped an eye-popping £375 billion into the UK economy
through this system. Note that the aim of the central bank here is still to bring down
interest rates faced by companies and households and, most importantly, to create
new money for use in an economy.
The monetary impact of quantitative easing spills out of asset trading in the
repo market, and again
Figure 14.3
is useful as an aid here. If a central bank such
as the Bank of England wishes to inject money into the economy it can purchase
assets (such as government bonds or high-quality debt issued by private companies)
from insurance companies, pension funds, banks or non-financial firms. The
outcome - regardless of the particular assets purchased - is that the seller's bank
account is credited and the system finds itself with more funds. Moreover, when a
government buys assets in such large amounts it tends to push their price up and
the yield rate down, as the rate of return on these types of asset is usually fixed.
In theory, therefore, quantitative easing increases money supply and lowers long-
